The Surprising Way Credit Cards Make Money

Americans live in credit card paradise. In a matter of minutes, an 18-year-old with  no job, no ID, and no credit history can get access to a thousand real American dollars  — all from the comfort of their living room. Applying requires little more than a birthday and  social security number.

When it comes to income, banks often rely on the “honor system. ”  And decisions are usually made on the spot. And if that same 18-year-old manages  to click either the “pay in full” button every 30 days or the “Auto Pay”  button just once, in 6 months to a year, he or she will be officially ordained as “prime,”  or even “superprime” by the credit score gods.

Now inducted into the wonderful world of  credit card rewards, he or she will earn, say, 6% cash back on groceries, 5%  on travel, and 4% on restaurants. Simply by using their card (something they’d  likely be doing anyway) — a reasonably sophisticated consumer can expect to earn  hundreds of dollars a year this way. And did I mention this is non-taxable “income,”  and thus 6% is really more like 8 or 9%?

Many cards offer free TSA PreCheck,  free Disney+, free travel insurance, free grocery delivery, free Uber rides,  free airport lounges, and so. much. more.

And for those willing to spend a few  extra hours applying for new cards, they can expect to earn not hundreds but  thousands, in the form of “welcome bonuses. ” To call this “generous” would be a massive  understatement. Who in their right mind would lend a random, unemployed high school  student a thousand dollars over the internet with zero collateral?

You wouldn’t. And  you definitely wouldn’t do it for free. But don’t forget the first law of business school: if at first a multi-billion-dollar corporation  appears generous — especially if its name is “J.

P. Morgan” — look closer, because  someone is surely getting ripped off. Let’s call it the “law of conservation  of corporate generosity.

” For every lucky cardholder redeeming free  business-class flights to Cancún, there’s another one still paying 20% interest  on a car repair from three years ago. A whole cottage industry of personal finance gurus exists almost exclusively to tell you  to never, ever, ever use a credit card. And not without reason: they cleverly combine  the sky-high interest rates of a payday loan, the dangerous convenience of a mobile  app, and the psychological abstraction of casino chips.

Plus, because  they offer “revolving” credit, you can keep taking on more debt, month  after month, even as you fall behind. This is the dark underbelly of the industry. And given these two extremes —  free trips to Mexico for some, crippling debt for others, it’s hard not to  assume that one is subsidizing the other; that companies lose money on the first type of  customer so they can make it back on the second.

But there’s an issue with this theory. It  violates the second law of business school: if at first a multi-billion dollar  corporation appears to be losing money, look closer, because, unless  it’s VC-funded… it isn’t. Credit card companies might be evil, but don’t  sell them short — they definitely aren’t dumb.

Here’s the thing about people who pay 20% interest on a car repair from three years  ago: sadly, we know who they are. This is a graph of credit scores from 480 (bad)  to 840 (good). This is the amount of interest they pay and this is the amount of fees.

Notice  a pattern? Yeah. So do the great minds at Bank of America.

If these customers with high  credit scores reliably lost them money, banks wouldn’t be handing them  out cards like they were candy. Credit card companies, despite their  best efforts to appear otherwise, are not charities for rich people. There’s  no reason for them to steal from their poor customers and give to their rich ones when  they could just… skip that second part.

Now, make no mistake: banks will  gladly — unapologetically! — wait years for their customers to miss  a payment and then pounce on the opportunity to charge 20% interest.  Clearly, this is a good business!

But it’s not a great one. Frankly, there’s  only so much interest they can earn. Profiting off a small subset  of your customers is nice.

Profiting off every transaction is even  better. And that’s exactly what they do. The biggest myth about credit cards is that you  can outsmart Citibank simply by paying your bill on time.

Quite the contrary. The most profitable  customer is the one with a perfect credit score, who always pays their balance, and who uses  a fancy rewards card with lavish benefits. Here’s why: When you, the customer, buy a banana, your  money typically travels through not one, not two, but three intermediaries to get to  Walmart, the merchant.

There’s your bank, there’s Walmart’s bank, and there’s the  network that lets them “talk” to each other. And for the privilege of passing along  a series of numbers over the internet, each of these companies takes a slice  of the pie. A healthy slice of the pie.

How healthy, exactly? Well, the fact that not one, not two,  but — say it with me — three independent middlemen can become fabulously  rich in the process should tell you everything you need to know about  how little is left over for Walmart. Here’s another clue: In 2008, Home  Depot spent more on these credit card fees — called “interchange” — than on health  care for its three hundred thousand employees.

That’s a lot of money. Interchange varies by network,  card, merchant, transaction, and even method (typing a credit card number,  for instance, is more expensive than swiping it), but it consists of a fixed per-transaction  cost plus a percentage of the total. That fixed part, by the way, is why some stores  have a 5 or $10 minimum purchase requirement — at small amounts, the per-transaction fee  eats up a majority of their profit.

But the percentage is where credit card  companies really make their billions. Imagine how insanely rich you could  become by taking a tiny cut of nearly every purchase made in America! You and  I get 2% cash back on groceries.

Chase gets 2% “cash back” on everyone’s groceries.  And gas. And dinner.

And travel. And so on. Now, credit card companies justify these fees  by arguing that they drive additional spending.

Using a card is fast, it’s convenient,  and you don’t see the money leave your bank account for 30 days. All of these  things are undeniably good for merchants. It’s also almost certainly true that  consumers spend more, on average, when they know they’re earning  points or miles or cash back.

Walmart and Apple and Nike tolerate  an additional, say, 1% interchange for rewards cards in the hope that they’ll  lead to at least a 1% increase in spending. The question is: at what point do these  returns start to diminish? At what point does the cost of interchange grow larger than  the additional spending they supposedly induce?

Well, American Express has built its whole  business around testing these limits. What it cleverly realized is that most  credit card companies are playing the wrong game entirely — competing for merchants  by keeping interchange at an acceptable level. Sure, Visa and Mastercard are accepted virtually everywhere.

But the cost of this  ubiquity is lower interchange. AmEx, on the other hand, decided  to forget about pleasing merchants and focus exclusively on competing for customers. Instead of lowering interchange,  it drastically raised it.

By doing so, it could turn around and offer  you and me much better rewards. These rewards, in turn, attract much wealthier cardholders.  Naturally, wealthier cardholders spend more money.

Finally, more spending means more  interchange revenue — completing the circle. More interchange, more rewards, more spending…  more interchange, more rewards, more spending. Play this out over the course of decades and  you get the American Express Platinum — a card that costs more to use than the  average Colombian earns in a month.

And you can bet that the kind of  person who pays $695 a year for access to a credit card spends a lot of money  and thus generates a boatload of interchange. What AmEx figured out is that you  don’t have to be in everyone’s wallet. You only have to be in the 20%  of wallets that do 80% of all spending.

But as it moved further and further up-market,  raising the bar for the amenities consumers expect, it provoked a rewards arms race. After it  began building airport lounges, for example, Chase was forced to do the same, launching the “Sapphire  Reserve,” its $550-a-year Platinum competitor. And in the process of taking rewards to their  current, lavish extreme, AmEx eroded the credibility of its argument: that these cards  earn their keep by inducing additional sales.

Sure, when its cardholders spent,  say, six percent more on average, Target could stomach paying,  say, 3% more on interchange. But, in 2006, its cardholders spent nearly four hundred percent more than  the average Discover cardholder. Clearly, the shiny surface of the Platinum card  doesn’t magically cause its holders to spend four hundred percent more at Target.

Instead, this coveted status symbol merely attracts  the kind of person who already spends more. Similarly, the Platinum card offers a  $300 credit at Equinox, a high-end gym. Target and Home Depot, in other words, indirectly pay for these memberships. 

And it takes a wild imagination to see how subsidized trips to the sauna lead  anyone to buy more pizzas or power tools. American Express is not really in the  business of lending money. In fact, many of its cards aren’t actually  “credit cards” at all.

Technically they’re charge cards, since you’re  not allowed to carry a balance. Nor is it really in the payment  processing business — these days moving money around on the internet is  what you might call a “solved problem. ” No, it’s becoming increasingly clear that it’s  really in the business of hoarding wealthy Americans.

What it specializes in,  its “core competency,” is acquiring and retaining the “right” clientele so it can then charge retailers extortionate interchange  fees for access to these big spenders. It’s not adding value — stimulating more  purchases — it’s extracting value — acting as a kind of toll booth between Apple and the  wallets of doctors and lawyers and bankers. There’s a reason, after all, the Platinum  card offers Equinox.

There’s no way Target would pay this much interchange for  the kind of customer who goes to Planet Fitness. But it is willing for the kind that  frequents a $400/month “luxury health club. ” Now, you might be thinking: don’t merchants  simply pass these costs on to you and I?

If Chase charged 2. 1% interchange for its  Sapphire Preferred card, you’d expect Target to then charge us a 2. 1% fee at checkout to use it. 

And since we’d only earn a maximum 2. 1% cash back, rewards would become a pointless exercise —  paying at least a dollar to get a dollar back. Suddenly forced to absorb the  cost of our “free” vacations, we’d all settle for basic debit cards instead.

But there are two reasons that doesn’t happen. First, while credit card companies  charge merchants different fees for their different cards, they forbid  merchants from doing the same to you and I. Sure, merchants can impose credit card  surcharges — you’ve seen them before — but they have to be the same for every card. 

Nor can they choose to accept one card and not another. Each network — Visa or Discover  or AmEx or Mastercard — is all-or-nothing. In practice, this means no one is truly  paying the cost of their own rewards.

Some cardholders unknowingly pay into  the pot while others withdraw from it. And second, as any small  business owner will tell you, there’s nothing in the world that customers  hate more than fees. They will gladly, cheerfully pay $10 more for their goods before  they’ll pay even one dollar in fees.

And rest assured that if your neighborhood bakery  does dare impose a fee, the outrage — the raw indignation — will be squarely directed at its  owner, Grandma Debbie, not J. P. Morgan Chase.

Understandably, then, most businesses  take the path of least resistance: baking the average cost of interchange  into their prices for all customers. What this means is that not only  are the middle-class Costco credit card users paying for the vacations of  the upper-class Platinum cardholders, but lower-class cash customers are too. In 2010, economists at the Federal Reserve  estimated that the average cash household loses $149 a year this way and the average  card household receives an incredible $1,133.

And “cash” really does mean “poor. ” Those making  less than $25,000 a year do less than 5% of their spending with credit cards, while that number is  66% for those making over two hundred thousand. As Georgetown Law Professor  Adam Levitin has pointed out, families on food stamps are  effectively supporting the 1%.

In other words, cardholders don’t  see the true cost of their rewards, they only see the benefits: their points and  miles and “free” vacations. But even if they did, they don’t pay those costs — someone else does. So, the poor do subsidize the rich  — just not in the form of interest.

And the house never loses. Remarkably,  credit card companies make money on both. Now, merchants, of course, don’t like this.

They get blamed for fees they didn’t set and  they lose sales from these higher prices. But only a few — Costco and eBay, for instance  — are brave enough to call AmEx’s bluff, refusing to accept its cards and betting that  these customers will find another way to pay. And even fewer are bold enough to take the  nuclear option — refusing credit cards entirely.

That leaves only one way to  stop this tax on the economy and regressive transfer of wealth: regulation. American viewers may be surprised to  learn that we alone live in credit card paradise. No other country on  earth offers such lavish benefits.

The American Express Gold card, for example,  is also available in the Netherlands, but without virtually any of the perks  that make it popular in the States, like four points per dollar spent at  restaurants and $400 a year in credits. Unsurprisingly, then, many Europeans don’t bother. The average American owns 3.

9 credit cards.  France, meanwhile, has just 0. 27 cards per capita.

The reason for this is simple: in  2015, the EU, like many governments, set a maximum interchange rate. And 0. 3% doesn’t  leave enough room for free trips to Hawaii.

We know these same rules would work in America  because… they do. After the Great Recession, Congress capped interchange for debit  cards at nearly zero. As a result, good luck finding a debit card that  offers $400 a year in “dining credits.

” The problem, of course, is that this is all very  obscure and complicated. When the average American hears the word “interchange,” in typical American  fashion, we think of driving. We have no idea that we — or our neighbors — are ultimately paying  higher prices.

And that’s by design — Discover is happy to let us think we’re getting one over  on it as it rolls around in a giant pile of money. Since only the benefits of credit cards are  visible, any politician who wanted to regulate them would be met with confusion and anger: “Why  are you trying to take away my precious points? ” They’d also have to contend with the large and  growing influence of “points hacking” websites, which earn kickbacks from the very same  credit cards they, quote, “recommend.

” Indeed, after a bipartisan group of  Senators proposed the Credit Card Competition Act of 2023, sites like  “The Points Guy” lobbied against it, using their typical air of neutrality  (with small print disclaimers about their conflict of interest) to portray  the bill as bad for consumers. This is probably a good time to let you  know that… none of the cards mentioned in this video paid to be here. And unlike the sneaky  world of credit cards, today’s sponsor, Nebula, has a simple and honest business model: you give  us three bucks a month and we give you exclusive, high-budget Originals like Tom Nicholas’ new  documentary about the rise of Baby Boomers, Neo’s beautifully produced “Under Exposure”  series, and my six-part series about China.

When you sign up to Nebula, you are our  customer. Not banks, not advertisers, and definitely not credit card companies.  This really matters because it means our goal is to not to trick you with  sensational clickbait but to keep you satisfied, by building the best viewing  experience and making the best videos.

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